By: Steve Smith
Earnings trades can be trap shoot but there is one predictable pricing behavior that savvy option trader use to produce steady profits.
We’re heading into earnings season and many people choose to use options to play these high risk/reward situations. The biggest mistake novices make is purchasing puts or calls outright as a means of directional “bet.” They are usually disappointed with the results as even if the stock moves in the predicted direction the value of the option can actually decline and result in loss despite being “right.”
Don’t Get Post Earnings Premium Crushed
The problem is they failed to account for the post earnings premium crush (PEPC) in which implied volatility contracts sharply immediately following the report no matter what the stock does. You’ll often hear traders cite what percentage move options are “pricing in” o the earnings. The quick back of the envelope calculation for gauging the magnitude of the expected move is to add up the at-the-money straddle.
This article does a great job of explaining how to use the straddle to both assess expectations and potentially profit.
For example; on Tuesday April 6 Constellation Brands (STZ) closed at $151.50 last and April $120 straddle (the $150 call +$150 put) which expired that following Friday closed at $9.30 suggesting a 5.3% or $8.20 price move. Note, I adjusted for the fact the options still had 9 days until the 4/15 expiration. On Wednesday morning the wine and beer conglomerate posted much better than expected earnings line earnings and the stock opened up just popped $9 to $160 per share. Anyone that bought call options ahead of the report was likely rubbing their hands with glee in anticipation of a huge profit.
But because the implied volatility and hence the premiums get crushed immediately following the event the profits would have been minimal despite the monster move. This is especially true if you had used the wrong approach. For example, the $160 call was actually down $0.50 from $2.75 prior to the report to $1.25 the following morning. The lesson: don’t buy out-of-the-money options prior to earnings in hopes of hitting a jackpot. These lottery tickets rarely pay-off.
Once option traders are armed with this bit of knowledge they to advance to use spreads to mitigate the impact of PEPC when looking t make a directional bet. Some will graduate to getting this predictable pricing behavior in their favor by selling premium via strangles or the more sensible limited risk iron condors. But these strategies still carry the risk of trying to predict if not the direction, than the magnitude of the move.
The Pre-Earnings Trade
The true professionals pursue a safer and more reliable path of positioning in anticipation of the increase in implied volatility that precedes earnings and avoids the actual event all together. Just as PEPC is predictable so is the pumping up of premium leading into the event; it’s just more subtle in that it occurs incrementally over the course of many days.
One strategy for taking advantage of rising IV leading into earnings is calendar spread in which you sell an option that expires prior to the earnings while simultaneously purchasing one that expires after the event. Like any calendar spread it will benefit from the accelerated decay of the nearer dated options sold short. But this has the added tailwind of as earnings approach the option which includes the earnings will see it IV rise causing the value of the spread to increase. To keep the position delta neutral both put and call calendars should be established. These positions must be established in advance and closed before the actual earnings. The profits might not be as dramatic as catching a huge post earnings move but they can be substantial.
I was look through my notes in from the past few quarters trying to identify some patterns and I came across an unusual instance in Facebook (FB) from 2015’s first quarter. As of the first week of April it was apparently unclear exactly when the company would release their earnings. This caused all the weekly options to pump up the premiums to include the possibility of the event.
A colleague of mine noticed this and structured a calendar spread by selling options that expired 4/17 and buying the 4/24 expiration. When the company confirmed its earnings would be released April 22, it caused an immediate shift in the IV skew as the premiums for the options that would capture the event got pumped up. Without any movement underlying share price in moving the double calendar went from $1.55 to $2.40 overnight. My friend closed the position and scored a huge profit without assuming any of the actual event risk.
Now this is a somewhat unusual situation in that apparently FB’s exact earnings date was uncertain. But it illustrates the power of how the shift in IV leading to the event can be used to your advantage.
With weekly options there should be plenty of situation in coming weeks to take advantage of the rise in IV leading into earnings. This site https://www.optionslam.com/ provides a good starting point of a list of names and their options specific pricing tendencies.
With most offering weekly options there should be plenty opportunities for double calendars. As always, do your own research and confirm the reporting dates but this offers a great starting point.